By Willem H. Buiter & Anne C. Sibert
LONDON – Amid the political turmoil of outgoing British Prime Minister Liz Truss’s short-lived government, the Bank of England has found itself in the fiscal-financial crossfire. Whatever government comes next, it is vital that the BOE learns the right lessons.
On September 23, Truss’s government announced a large, unfunded fiscal-stimulus package that undermined the BOE’s price-stability mandate and caused government-debt and foreign-exchange markets to malfunction. To prevent systemically important markets from seizing up, the BOE postponed its planned offloading of government bonds (gilts) and instead purchased more. But these unsterilized (monetized) asset purchases amount to an expansionary monetary policy, which will further frustrate the BOE’s efforts to bring down inflation – unless and until the purchases are reversed.
Unfortunately for the BOE, it had no choice. Financial stability is a precondition for sustainable price stability, so it is a central bank’s overriding concern. When the circumstances demand it, central banks must act as lenders of last resort (LOLR) to preserve or restore funding liquidity for systemically important counterparties. They also must serve as market makers of last resort (MMLR) or buyers of last resort (BOLR) to maintain or restore market liquidity in systemically important financial markets.
The BOE got its latest interventions partly right, but it also made mistakes. When market participants in the UK – notably liability-driven investment (LDI) funds – panicked, the BOE intervened, on September 28, with a powerful statement about its willingness and ability to act. Purchases would be carried out “on whatever scale is necessary” to restore orderly markets. Moreover, the Treasury would fully – and quite properly – indemnify the operation for any losses incurred.
But the BOE undermined this show of force by putting a time limit on its emergency intervention. It stated that the planned sales from its Asset Purchase Facility would be delayed from October 3 to October 31, and that it would purchase up to £5 billion ($5.4 billion, as of September 28) of gilts per day for 13 days. These dates were offered not as mere estimates but as a firm interval.
On October 10, the BOE reported that it had bought only around £5 billion of gilts in total over the course of eight daily auctions. It was a demonstration of credibility at work. If market participants believe that the MMLR is willing and able to intervene “on whatever scale is necessary” to restore order, the actual intervention required may be small. In the case of the European Central Bank’s Outright Monetary Transactions (launched in 2012), no actual purchases were needed to restore market functioning.
With £60 billion of unused capacity in its emergency facility, the BOE then announced that it would increase the maximum size of the remaining five auctions to £10 billion each. It also added index-linked gilts to the program and initiated a temporary LOLR facility, the Temporary Expanded Collateral Repo Facility, to extend further assistance to stressed LDI funds; it eased collateral requirements for its regular Indexed Long-Term Repo operations; and it made additional liquidity available through a new, permanent Short-Term Repo facility, launched the week of October 3.
All this made sense. But the BOE’s continued insistence that its emergency gilt-purchase program would end on October 14 was unhelpful, because it contradicted the assertion that it would carry out purchases on whatever scale it deemed necessary. Moreover, that date was never credible. If bondholders were to start dumping gilts again on October 15 or any later date, the BOE would be right back to acting as a BOLR.
It is unclear whether the BOE’s emergency gilt purchases were on penalty terms, which are necessary to minimize excessive risk-taking by market participants who know that the central bank will intervene should fire sales or other dysfunctional behavior threaten market functioning. Penalty terms that apply when markets are disorderly are an important complement to well-designed regulations constraining excessive risk-taking when markets are orderly. But it can be difficult for a central bank to determine a purchase price that is both materially more attractive to would-be sellers than the disorderly market price as well as less attractive than the (unobservable) orderly market price.
A separate but important issue is that the BOE’s Monetary Policy Committee played no meaningful role in creating and implementing the emergency program. That is surprising, considering that the new gilt purchases will complicate and delay the process of bringing inflation back down to the target rate. According to a statement by the BOE’s Deputy Governor for Financial Stability, Jon Cunliffe, the MPC was merely “informed of the issues in the gilt market and briefed in advance of the operation, including its financial-stability rationale and the temporary and targeted nature of the purchases.”
By emphasizing the temporary and targeted nature of the purchases, Cunliffe seemed to be suggesting that they do not constitute monetary policy operations. But, in that case, was the specific emergency program – both the unsterilized asset purchases and the postponement of the asset sales – formally recommended by the Financial Policy Committee, whose mandate is financial stability? Cunliffe’s statement is ambiguous on this question: “The FPC was engaged ahead of [the program’s] launch, recognizing the risks to UK financial stability from dysfunction in the gilt market. The FPC recommended that the Bank take action, and welcomed the Bank’s plans for temporary and targeted purchases in the gilt market on financial stability grounds at an urgent pace.”
Given that these emergency operations have both financial-stability objectives and monetary-policy implications, they ought to have been properly approved by all the designated decision-making bodies – the FPC and the MPC. If that was not the case, the program’s legitimacy may be significantly undermined.
Copyright: Project Syndicate, 2022. www.project-syndicate.org
